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Christine Roberts

Loans/Deemed Distributions

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This question relates to a cash balance plan but is asked also in relation to DB plans in general. Following default on a plan loan without a distributable event (hence a deemed distribution), must the plan continue to charge the same interest rate on the outstanding balance as applied prior to the default? It would be administratively preferable to reduce the interest rate, following the default, to a level equal to the amount that the plan is paying on the loan balance (e.g., from 8% down to 5%), otherwise the higher interest rate gradually erodes the account balance. It would seem that the interest rate reduction would not be tantamount to an actual distribution because the participant retains the right to repay the loan at any time.

Any comments or conjecture on the Service's likely take on the issue would be appreciated.

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I would argue against an interest rate reduction for several reasons.

In relation to the plan loan, the plan sponsor (or is it the plan administrator?) is playing the role of a "bank." As a fiduciary, it must set the interest rate consistent with what other financial institutions in the geographic area are charging for similarly situated (i.e. similarly secured) loans. Now, if you were a bank and a secured loan that you had issued was defaulted on, and if you couldn't (for various reasons) foreclose on the security, would you as the bank reduce the interest rate on the loan. I wouldn't.

Also, as a fiduciary, how could you justify to the Department of Labor why you reduced the interest rate to 5% when you could otherwise get 8%?

Finally, while I understand the administrative simplicity argument, the counter argument is that reducing the loan interest rate to 5% is taking away from the plan the ability to encourage the Plan Participant to repay the loan. After all, while the loan is outstanding, the Participant is "losing" 3%. This alone should encourage the Participant to repay the loan as soon as he has funds available. He might pay this off in 3 or 4 years; if you reduce the interest rate to 5%, he might as well wait until he turns age 65! (In fact, I wouldn't blame the Participant from waiting until age 65, since he would in effect have a long term loan at 5%, too good a deal to pass up.)

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I agree with Richard; you shouldn't reduce the interest rate. In fact, my understanding is that commercial banks typically increase the interest rate after default (to encourage borrowers to correct the problems. My concern is that if the DOL ever focused on this problem, they might mandate the use of a higher interest rate after default.

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Guest Mike Melnick

If the plan sponsor wants to use the lower interest rate after the default, I do not necessarily see any compliance problems. The sponsor must comply with the rule that the interest rate be reasonable (based on the commercial market for similar loans) in order to avoid a deemed distribution in the first place. Once the deemed distribution has taken place, the situation changes.

Now the issue becomes the following: does charging a low interest rate mean that there is no longer a loan at all (so that an actual distribution has taken place) violating the in-service distribution rules? Probably not. A loan is legally still a loan even if the interest rate is very favorable. And, as the original post pointed out, the participant still has the right to repay the loan and restore their balance.

I also doubt there is a fiduciary issue, as long as the defaulted loans represent a portion of the plan assets that is too small to be material.

So if the sponsor wants to provide this "benefit" to the defaulting participant, and it is administratively simpler, why not?

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